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Stocks can go back to record highs if the Fed can fix the bond market, strategist Jim Paulsen says

Key Points
  • "The Fed needs to take out the inverted curve fear more than they need to address the fundamental fallout from the trade war," says Leuthold's Jim Paulsen.
  • That so-called inverted yield curve, when shorter-term bonds deliver higher rates than longer-term bonds, has historically signaled a possible recession.
  • "If they do that, then I think the underlying economy is going to be OK and the stock market goes on to new highs," Paulsen predicts.
VIDEO6:2006:20
The inverted yield curve is the biggest risk in the market, says strategist

Stocks could continue their run all the way back to record highs if the Federal Reserve addresses the current upside-down yields in the bond market, the Leuthold Group's chief investment strategist told CNBC on Wednesday.

"The Fed needs to take out the inverted curve fear more than they need to address the fundamental fallout from the trade war," Jim Paulsen said on "Squawk on the Street. " "If they do that, then I think the underlying economy is going to be OK and the stock market goes on to new highs."

That inverted yield curve, when shorter-term bonds deliver higher rates than longer-term bonds, has historically signaled a recession on the horizon.

"Fundamentally, the economy is in not that bad of a shape," Paulsen said. He said investors are "overblowing the negative impact of the trade war" between the U.S. and China.

Talk of the Fed keeping interest rates on hold for a while has shifted to calls for rate cuts to support any slide in economic growth. Hopes for a rate reduction were supporting stocks again, after Wall Street saw its second-best day of the year on Tuesday. As of Tuesday's close, the was about 5% below its all-time intraday high of 2,954, set on May 1.

Paulsen said the U.S. couldn't have picked a better time to increase tariffs because price pressures are so low that the Fed would actually welcome any increases in inflation. U.S. tariffs on Chinese imports would have to go on for a "considerable period of time" before price increases would cause any troubling inflation, he added.

Treasury yields have been falling over the past month as trade and economic tensions between the U.S. and China have created uncertainty and investors have sought the perceived safety of the bond market. This has pushed fixed-income prices higher and yields, which move inversely, lower.

However, the decline of longer-term bonds has been more rapid, with the rate on the benchmark 10-year Treasury below that of the 3-month note. The 10-year yield was trading around 2.11%, about 20 basis points below the 3-month. Investors can usually expect to get a better return for holding debt for a longer period of time.

The U.S. and China are currently stalled on talks to find an end to the trade war between the two largest economies. In May, both of the countries increased duties on one another, which has rattled markets.